SEP, Solo 401k Or SIMPLE: Which Shelters More?

My first full year working for myself, I did the thing everyone does and opened a SEP in March because a SEP was the account I had heard of. It took me until the following year to work out that on the money I had actually earned, I had given myself about a third of the room I could have had.

The accounts are not equally generous, and the gap is widest at exactly the income level where most people start.

The three accounts

A SEP IRA, which stands for simplified employee pension, is funded entirely by the business. You contribute a percentage of compensation, and if you have eligible employees you generally have to contribute the same percentage for them.

A solo 401k, sometimes called an individual 401k, is a regular 401k plan with exactly one participant, you, plus a spouse if they work in the business. Because it is a 401k, you contribute in two capacities: as the employee making a salary deferral, and as the employer making a profit sharing contribution on top.

A SIMPLE IRA is the small-business plan with the low administrative burden. Employees defer part of their pay, the employer has to either match or make a flat contribution, and the deferral limit is meaningfully lower than a 401k.

Why the SEP arithmetic feels worse than it reads

The rule most people quote is 25% of compensation. If you are an employee of your own corporation drawing a salary, that is close to what happens.

If you are a sole proprietor or a single-member LLC filing on a Schedule C, the calculation is circular in an annoying way. The 25% is applied to net earnings, which are your profit after subtracting half your self-employment tax and after subtracting the contribution itself. Solve that and the 25% collapses to roughly 20% of your net profit.

On $60,000 of net profit, roughly 20% is about $12,000, and the precise figure lands a little under that once half the self-employment tax comes out of the base. Call it $11,000 to $12,000.

That is the entire SEP. There is no second lever.

Where the solo 401k pulls away

The solo 401k gives you the same employer contribution, so the same roughly $11,000 to $12,000 on $60,000 of profit. Then it adds the employee salary deferral, which is a flat dollar allowance rather than a percentage of anything.

Say the deferral allowance in the year you are reading this is $23,000, and check the real figure. On $60,000 of profit, you would contribute $23,000 as the employee and about $11,500 as the employer, which is $34,500.

$34,500 against $11,500.

Three times the room, on the same income, for the same year of work. The deferral does have to come out of earned income, so you cannot defer more than you made, but at $60,000 that constraint is not binding.

The advantage narrows as income rises, because at some point the percentage-based employer contribution alone runs into the overall annual cap that applies to both accounts. At $300,000 of profit the two land in similar territory. At $60,000 they do not.

What SIMPLE is for

A SIMPLE has a lower deferral limit and a mandatory employer contribution, so as a one-person plan it is the worst of the three on room per dollar earned. Say the deferral limit is $16,000 and the required employer match is 3% of compensation, which on $60,000 is $1,800. That is $17,800, ahead of the SEP and well behind the solo 401k.

Its reason to exist is employees. If you have three or four people and do not want the administration of a real 401k plan, a SIMPLE is genuinely simple and the required contribution is smaller than what a SEP would force you to give them.

If you also have a job

This catches almost every freelancer with a day job. The employee salary deferral limit applies to you as a person rather than to each plan, so whatever you already put into your employer's 401k comes off what you can defer into a solo 401k in the same year.

Defer the full allowance at work and there is nothing left to defer into the solo plan. The employer profit sharing piece works differently and is calculated per business, so you can still make that contribution on your self-employment income even with a maxed workplace plan.

Which means that for a side business, a SEP and the employer half of a solo 401k often come out level. The solo plan's advantage only appears once the side income becomes the main income.

There are Roth versions of most of this. A solo 401k can generally accept Roth deferrals, meaning you pay tax now and take it out untaxed later, and recent law extended Roth treatment into places it did not previously reach. Whether that helps depends on your bracket this year against your expected bracket later, which is a guess you are allowed to hedge by splitting.

The deadline is the part that bites

A SEP can usually be opened and funded right up to your tax filing deadline, extensions included, which is why so many people end up with one. It is the account you can still open in September for last year.

A solo 401k has historically needed to exist before the end of the tax year for the employee deferral piece to count, and recent law has loosened parts of that for sole proprietors setting up a first-year plan. The rules here have moved more than once, so confirm the current deadline with the provider before you count on it.

That timing difference is the real trap. The account with three times the room is the one with the earlier deadline, so the person who waits until filing season discovers their choice has already been made for them.

Pick one before your filing deadline, and if you are anywhere near the end of a calendar year, pick before December instead. Then go look at what your net profit actually was last year and run the 20% on it, because that single number tells you whether the difference between these accounts is worth an hour of your time or worth twenty thousand dollars.